October 06, 2003,
Last month's Group of Seven meeting in Dubai was extraordinary. The U.S. persuaded the world’s industrial powers to endorse "flexible" currency exchange rates. The move was clearly a jab at Japan and China as well as a signal to the world that the G-7 countries are willing to engage in mercantilist beggar-thy-neighbor policies that could lead to the ratcheting up of the worldwide inflation rate.
The experience of the 1970s showed us that an unhinged monetary policy accompanied by deliberate monetary devaluations only leads to inflation and does not have a long-term effect on a country’s trade balance. It is sad to see the most developed nations leading the world economy down the wrong path.
If the G-7 message has any effect on the world’s central banks, the worldwide inflation rate will unambiguously rise. Unfortunately, the actions of the G-7 are even worse if one considers the changes taking place within the G-7 central banks.
In Europe, Wim Duisenberg is stepping down as president of the European Central Bank. During Duisenberg's tenure the ECB stuck to its mandate of keeping the European inflation rate to a 2 percent target range, irrespective of the foreign exchange value of the euro and/or the real growth rate of gross domestic product in the European Monetary Union.
People have criticized Duisenberg, but he did not diverge from his legal mandate of sticking to a domestic price rule (where the level of prices provides a signal for central-bank action see more below). That's a great job he kept the inflation rate within the mandated range. He did what his job description said he should do. The failure, however, of the EMU cannot be attributed to monetary policy. Rather, it is attributable to the euroesclerosis produced by a dirigiste economic policy with a Keynesian bent.
The outlook for the EMU is at best slightly worse during the next few years. The incoming EMU president, Jean Claude Trichet, is supposed to be a better communicator than his predecessor. According to press reports, Trichet will be more likely than Duisenberg to add other objectives to ECB monetary-policy responses. Such attempts to regulate the real economy through monetary policy will invariably lead to a higher inflation rate.
Comments made by Alan Greenspan at the Jackson Hole conference in August only add to the disturbing monetary outlook. At Jackson Hole, the esteemed chairman of the U.S. Federal Reserve Bank trashed the inflation-targeting policies that have been so successful in both Europe and the U.S. He made the argument that his judgment alone is better than any decision-rule such as inflation targeting. That's too bad Greenspan's judgment is not as good as he claims. If he continues on this course and abandons inflation targeting, U.S. inflation will become more volatile and perhaps slightly higher.
The implication for the rest of the world could be very damaging, especially if the G-7 has their way.
Why? First, the inflation rate will rise and become more erratic in both the U.S. and the EMU if the two regions’ central banks abandon their inflation targeting. Second, by forcing the rest of the world to "float" their currencies in this case, to make countries un-link their currencies from the dollar or the euro the G-7 is in effect forcing countries to decouple themselves from the stable inflation rate that both the U.S. and the EMU have enjoyed.
Remember, when other countries fix their currencies to the U.S. dollar and/or the euro, they are effectively importing the U.S. and EMU monetary policies. (Hong Kong is a prime example of this.)
We learned in the 1970s that countries with depreciating currencies tend to have higher inflation than countries with appreciating currencies. And a higher inflation rate is not good for long-term fixed-income securities. If the rest of the world adopts the G-7 recommendations, the 20-year secular bull-market run of the bond market may very well be over, becoming a secular bear market.
Adhering to a "global" price rule, however, avoids this.
Operationally, the price rule is quite simple. Whenever domestic prices exceed those of a target range, a central bank will, through open-market operations, remove domestic money from circulation. That is, the central bank will sell bonds in the open market and receive cash in exchange. If you believe (correctly) that inflation is too much money chasing too few goods, the reduction in the high-powered money circulating the economy should lower the domestic price level.
Conversely, during periods when the price level falls below the target range, the central bank will increase the amount of money circulating in the economy by buying bonds in the open market. Since the government pays for the bonds by printing money, the higher quantity of money will lead to an increase in the domestic price level.
Finally, any country, if they choose, can adopt the price rule of another country simply by fixing to their exchange rate. In doing so a country is importing the inflation rate of the reserve currency country.
During the last decade we have witnessed the Tequila Effect, the Asian Contagion, and the Russian crisis among others. These experiences reinforce the point that whenever domestic central banks tinker with the domestic price rule by spending the inflow of foreign exchange during the good times, they do not have enough to finance the outflow during the bad times.
Perhaps China has benefited from the experiences of the emerging non-reserve currency countries. Hopefully China will not follow the bad advice of the G-7 and U.S. Treasury Secretary John Snow. That would be the worst possible course of action that China could take. So far, the Chinese have resisted, and they may have the willpower to continue doing so. If they hold their ground they will do the world and the financial markets a great service.
Still, one wonders if we're watching the demise of the global price rule. The U.S. postwar history illustrates a roundtrip of monetary-policy experiences with the price rule. It seems that we are at the beginning of another roundtrip. If we are, we better brace ourselves for a long bear market in fixed-income securities.
Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.